The Monetary System: Structure, Functions, and Policy

The Monetary System

What Money Is and Why It’s Important

Money is a fundamental component of modern economies, facilitating the exchange of goods and services. Without money, economies would rely on barter, which requires a double coincidence of wants—meaning both parties must have what the other desires. This system is inefficient and leads to wasted resources as individuals spend time searching for suitable trading partners. Money eliminates this inefficiency by serving as a universally accepted medium of exchange.

The Three Functions of Money

Money serves three primary functions in an economy:

• Medium of Exchange: An item that buyers give to sellers when they want to purchase goods and services.

• Unit of Account: The standard measure people use to post prices and record debts.

• Store of Value: An item that people can use to transfer purchasing power from the present to the future.

Wealth is the total of all stores of value owned by an individual or entity. Liquidity refers to how quickly an asset can be converted into the economy’s medium of exchange (money).

The Two Kinds of Money

Money can be classified into two main types:

• Commodity Money: Money that takes the form of a commodity with intrinsic value (e.g., gold coins, or even items like Ramen noodles in prisons).

• Fiat Money: Money without intrinsic value, established as money by government decree (e.g., the U.S. dollar).

The Money Supply

The money supply (or money stock) is the total quantity of money available in the economy. It includes:

• Currency: Paper bills and coins in the hands of the public.

• Demand Deposits: Balances in bank accounts that depositors can access on demand by writing a check.

Measures of the U.S. Money Supply

The U.S. money supply is measured using two main aggregates:

• M1: Includes currency, demand deposits, savings deposits, and other checkable deposits. M1 (May 2025): $18.713 trillion

• M2: Includes everything in M1 plus small time deposits, retail money market mutual funds, and a few minor categories. M2 (May 2025): $21.942 trillion

For many macroeconomic discussions, the distinction between M1 and M2 is not critical.

Central Banks and Monetary Policy

A central bank is an institution that oversees the banking system and regulates the money supply. Monetary policy refers to the actions taken by policymakers in the central bank to set the money supply. In the United States, the central bank is the Federal Reserve (Fed).

The Structure of the Federal Reserve (Fed)

The Federal Reserve System consists of:

• Board of Governors: 7 members located in Washington, D.C.

• 12 Regional Federal Reserve Banks: Located throughout the U.S.

• Federal Open Market Committee (FOMC): Includes the 7 Board of Governors and presidents of 5 regional Fed banks. The FOMC decides monetary policy.

Bank Reserves

In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans. The Fed establishes reserve requirements, which are regulations on the minimum quantity of reserves banks must hold against deposits. Banks may choose to hold more than the required minimum. The reserve ratio (R) is defined as:

$R = \frac{\text{Total Reserves}}{\text{Total Deposits}}$

Bank T-Account

A T-account is a simplified accounting statement that shows changes in a bank’s assets and liabilities. For example, a bank’s liabilities include deposits, while its assets include loans and reserves. If a bank has $10 in reserves and $100 in deposits, the reserve ratio is:

$R = \frac{10}{100} = 0.10 = 10\%$

Banks and the Money Supply: An Example

Consider $100 of currency in circulation. The impact of banks on the money supply can be illustrated in three cases:

1. No Banking System: Public holds $100 as currency. Money supply = $100.

2. 100% Reserve Banking System: Public deposits $100 in a bank, which holds all deposits as reserves. Money supply = currency + deposits = $0 + $100 = $100. Banks do not affect the size of the money supply.

3. Fractional Reserve Banking System: Depositors have $100 in deposits, borrowers have $90 in currency. Money supply = $90 (currency) + $100 (deposits) = $190. When banks make loans, they create money, but not wealth.

This process continues as loans are redeposited and re-loaned, multiplying the money supply.

The Money Multiplier

The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is calculated as:

$\text{Money Multiplier} = \frac{1}{R}$

For example, if $R = 10\%$, then the money multiplier is 10, and $100 of reserves can create $1000 of money.

Active Learning Example: Banks and the Money Supply

Suppose you find a $50 bill and deposit it in your checking account. If the Fed’s reserve requirement is 20%:

• Maximum increase in money supply: If banks hold no excess reserves, the money multiplier is $\frac{1}{0.2} = 5$. The maximum possible increase in deposits is $50 \times 5 = $250. However, since currency in circulation falls by $50, the maximum increase in the money supply is $200.

• Minimum increase in money supply: If your bank makes no loans from your deposit, the money supply does not increase.

The Fed’s Tools of Monetary Control

The Fed can change the money supply by altering bank reserves or the money multiplier. The main tools include:

• Open-Market Operations (OMOs): The purchase and sale of U.S. government bonds by the Fed. Buying bonds increases reserves and the money supply; selling bonds decreases them.

• Lending to Banks: The Fed can make loans to banks, increasing their reserves. This can be done by adjusting the discount rate or using the Standing Repo Facility.

• Reserve Requirements: The Fed sets regulations on the minimum reserves banks must hold. Lowering reserve requirements increases the money multiplier; raising them decreases it.

• Interest on Reserves: Since 2008, the Fed pays interest on reserves held at the Fed. Raising this rate encourages banks to hold more reserves, reducing the money multiplier.

Problems Controlling the Money Supply

Several factors can complicate the Fed’s control over the money supply:

• If households hold more money as currency, banks have fewer reserves, make fewer loans, and the money supply falls.

• If banks hold more reserves than required, they make fewer loans, and the money supply falls.

Despite these challenges, the Fed can usually compensate for changes in household and bank behavior to maintain fairly precise control over the money supply.